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#SaxoStrats
Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 11 June 2013 at 13:31 GMT

All change - Last station - All change...

Chief Economist & CIO / Saxo Bank
Denmark

Just as I felt confident in my new macro model: The Bermuda Triangle of Economics, or BTE, the market cycles are changing again. But this recent potential macro paradigm shift is interesting and can also be explained by the BTE model. I call this new phase in the market: Reality Hits as the Marginal Cost of Capital Normalises. I won’t try to make an acronym out of that one – too long.

The concept in the BTE model is that the world, so far, has been kept in artificial equilibrium by the way quantitative easing (QE) and fiscal policies bring support and endless liquidity to the 20 percent of the economy that mostly comprises large and already profitable companies and banks with good credit and good political access. The premise for supporting these companies is based on the non-existent wealth effect which unfairly culminates in supporting the haves to the detriment of the have-nots.

Meanwhile, the 80 percent of the economy that is composed of  productive, innovative, job-creating and less capital intensive small and medium-sized enterprises has been left to fend for itself. This segment is starved of credit and the upshot is the current malaise of low innovation and high unemployment.

Meanwhile, despite the economic distress, we have nothing but silence on the social discontent front, which can only be explained by the “success” of generous entitlements in the developed economies. Indeed, we are the Entitlement Generation. We are not compelled to challenge the government and central bank policies when more than fifty percent of the population benefits from income transfers directly from the state. This is a proof of the old game theory idea that the individual can be rational while the sum of individuals’ behaviour is irrational. This is another facet of the BTE.

What would upset this equilibrium?
The quick and intuitive response might be: more quantitative easing (QE). After all, the various central bank QE programmes have been firmly in the driver’s seat since 2008. But that’s not necessarily true – no, the real tipping point for the old paradigm is only reached via an increase in market volatility – something that appears to be unfolding at the moment. This is the point at which the market feeds back into the fundamentals by distrubing the false calm of equilibrium through a bloating of Value-at-risk (VaR) models.

When the market gets more nervous, volatility rises and the market jumps back and forth in a discontinuous fashion, moving away from the previous, very long one-way street lower driven by the compression of the risk premium from policy intervention and the resultant yield chasing (combined with benign inflation from the output gap). The culprit for this bout of volatility? Abenomics!

JGB contract historic volatility 50 and 100 days….(Source: Bloomberg LLP)

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For all its success in getting the Nikkei higher – and until recently, USDJPY as well, Abenomics also dramatically increased volatility in Japanese government bonds (JGBs), which was certainly not the intention. This increase in JGB volatility had people like me going short USDJPY as this acts as a brake on the simple idea that the USDJPY is a straightforward carry trade driven by the anticipation that Abenomics will have Japan having its cake and eating it too. When bond market volatility jumps, carry trades head south fast. And note how the JGB volatility saw contagion in the US bond market, with the US 30-year mortgage bond yield spiking 76 basis points recently.

The benchmark US 10-year US T-note has moved so much that the world’s most famous bond investor, Bill Gross, has lost 335 bps in his PIMCO Total Return Fund (PTTRX US Equity) from this year’s high in April. And he is down 169 basis points for the year-to-date in a fund that is known for its stability (Let me stress I am have big respect for PIMCO and Mr Gross and I am only using PIMCO Total Return Fund to make the point that even the best investors are hurting in this move – the PIMCO fund remains an outstanding outperformer over time relative to its peers).

30-year US Mortgage rate (Source: Bankrate)

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Pimco’s Total Return Fund

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So in short, the dramatic changes to fixed income and overall market volatility probably had 70 percent to do with the failure thus far of Abenomics to perpetuate the themes of QE and easy money. The reason for this (as I have stated several times) is that Japan has come far too late to the party. To use a nine-inning (very long) US baseball game as a metaphor, the BoJ came in the eighth inning, with the Bank of England potentially playing the ninth and final inning with the arrival of its new governor Mark Carney. The market has been thinking that QE is for eternity. But QE, like American baseball games, eventually comes to an end.

What makes Japan’s timing even worse is the fact that risk premiums were already extremely compressed – meaning that they were pushing on a string from the very start as macro players were already gunning for yield and leveraged to the hilt. Look at corporate and investment yield tickers like HYG and LQD, both of which are down in excess of five percent from the top. So what we are seeing now is also a “normalisation of risk premiums” – which is long-term very healthy and could at best mean that we are moving towards real “price discovery” again in the fixed income market. This will mean that we may begin to know the real price of money both in time and yield – at least in those sectors outside the control of the silly central bankers.

The other major area I want to touch on which makes this move in yield truly alarming is the trend in global current accounts. I have said a few times that the lack of recycling going forward is a major issue not only for the US, but certainly for all current account-deficit countries. (This has been a major drive for the sell-off in emerging market assets and currencies.)

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The trend is clear: From surpluses of five to seven percent of GDP – ergo, savings excess that needed to be recycled into US government bonds to avoid currency appreciation, Asia is barely showing a surplus and Brazil, Russia, India and China (the BRICs) will in my estimation move to a collective deficit inside the next 12 months, with Japan joining them on the current account deficit side. This means the biggest traditional institutional buyers of government debt have effectively disappeared, and may begin to even sell their holdings.

Are you worried yet? You should be.

The final straw
Looking at the US economy, the recent increase in yield has happened despite no real improvement in the underlying data. Imagine if the US economy started to slowly pick up from these low levels of activity over the summer due to lower energy prices, a “feel-good factor” in confidence, and a slightly better housing market. Are you ready for a three percent 10-year yield and a five percent 30-year mortgage rate in an economy with less than two percent real growth? Probably not, because no one else is either.

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Conclusion
I see the next few days as potential major game changers – the bloated VaRs will make people hedge and over hedge, and the normalisation process of rising risk premiums due and higher real rates (higher yield plus lower inflation) will lead to more selling off of those trades that have “worked so far”… and increase volatility in their own right.

I have not even mentioned the constitutional court ruling in Karlsruhe which the Anglo-Saxon press and banks with their usual naïveté of everything German have written off as a non-event. Reading Der Spiegel last night I got concerned about the consensus but judge for yourself. These are very much Decisive days for Euro: High Court considers ECB Bond buys.

Positions: (Alpha)

  • Short OAT – on bond volatility and Europe QE light
  • Short 10-year notes on above and technical break plus convexity hedging
  • Bought 101 USD call JPY put as insurance ……..(Higher US yield…)
  • Short gold (higher real rates…. Biggest conviction trade today)…
  • Looking to add short crude and long USDZAR, EURPLN again.


Safe travels,
Steen

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